I opened my individual retirement account -- better known as an IRA -- at the tender age of 18. There are a lot of things I wish I'd known, things the banker probably should have told me when she was helping me open the account.
Even after I opened my account, it was difficult to find resources in plain language to help me understand how retirement saving worked. Ten years and many, many hours of reading later, I'm writing the article I wish had existed when I first started.
First things first
What's an IRA, anyway? IRAs are special retirement savings accounts that you can use to invest and that have special tax advantages over regular bank accounts.
The best thing about an IRA is that the money or investments in the plan can grow tax-free. The account can rack up dividends, capital gains, and interest without the government taking a cut of them.
That's a pretty sweet deal, but the government can't give you an unlimited amount of tax breaks. That's why there are contribution limits on all types of IRAs. In 2017, the maximum contribution to an IRA is $5,500 if you're under 50 years old. If you're over 50, your contribution limit goes up by $1,000 to $6,500. Keep in mind that the contribution limit applies to all of your IRAs. So if you have three separate IRA accounts, the maximum you'd be able to contribute among the three is still $5,500, not $16,500.
Although there are a few types of IRAs, the two most common ones are Roth IRAs and traditional IRAs.
The main differences
The primary difference between a traditional and a Roth IRA is when you pay income tax on the money in the account. With a Roth IRA, you pay taxes on the money before you add it to the IRA -- which means that any qualified withdrawals from the IRA are tax-free. With a traditional IRA, you pay income tax on the withdrawals, but you may be able to deduct the amount of your contributions in the year you make them, giving you a big up-front tax break.
As with anything concocted by the IRS, there are rules for how much you can deduct from your taxes. As long as you (or your spouse) aren't covered by a retirement plan at work, you can deduct the full amount you contributed to your traditional IRA. The table below shows how much you can deduct based on your modified adjusted gross income (MAGI) if you do have a work retirement plan, like a 401(k) or a 403(b).
|Filing Status||MAGI||Allowable Deduction|
|Single or head of household||$62,000 or less||The full amount of your contribution|
|Greater than $62,000 but less than $72,000||Partial deduction|
|Greater than $72,000||No deduction|
|Married filing jointly or qualifying widow(er)||$99,000 or less||The full amount of your contribution|
|Greater than $99,000 but less than $119,000||Partial deduction|
|Greater than $119,000||No deduction|
|Married filing separately||Less than $10,000||Partial deduction|
|Greater than $10,000||No deduction|
Although anyone who has taxable compensation can open an IRA, not everyone can contribute to a Roth IRA because of the income limits on account holders. If you're filing your taxes as single or as head of household, then you can contribute the full $5,500 if your MAGI is less than $118,000. If you make more than than that but less than $133,000, then you can contribute a reduced amount. Anyone with a MAGI above $133,000 is not allowed to contribute to a Roth IRA.
See the table below for more details on contribution limits. Make sure you know where you fall before contributing to or opening a Roth IRA. If you fall outside the MAGI limits, a traditional IRA is likely a better fit for you.
|Filing Status||MAGI||Contribution Limit|
|Married, filing jointly||Less than $186,000||$5,500 or $6,500 if over 50|
|Greater than or equal to $186,000 but less than $196,000||Reduced amount|
|Greater than or equal to $196,000||$0|
|Married, filing separately||Less than $10,000||Reduced amount|
|Greater than or equal to $10,000||$0|
|Single or head of household||Less than $118,000||$5,500 or $6,500 if over 50|
|Greater than or equal to $118,000 but less than $133,000||Reduced amount|
|Greater than or equal to $133,000||$0|
There are also some differences when it comes to withdrawals. The short story is that you can withdraw whatever you've contributed to a Roth IRA penalty-free whenever you want, as long as you don't touch the earnings on the principal contributions. There are a few exceptions that allow you to withdraw contributions and earnings without any penalties, which you can read about here. Unencumbered withdrawals begin at 59-1/2. If you're worried that you may need some of that cash you're stashing away, then the Roth IRA might be the way to go.
It is much, much harder to make early withdrawals from traditional IRAs, but it can be done. If you'd rather avoid the temptation to raid your retirement account, then a traditional IRA might help instill some discipline, as you know you'll be smacked with a 10% tax penalty if you make a withdrawal before 59-1/2.
Keep in mind that traditional IRAs have required minimum distributions (RMDs) that you must start taking at 70-1/2. You're also not allowed to contribute to a traditional IRA once you've passed 70-1/2 years of age. Roth IRAs have no RMDs, and you can contribute until the day you die, whether you pass away at 70-1/2 or 110.
So what should you do?
Ultimately, the decision depends on your life circumstances. Since Roth IRAs save on taxes later, while traditional IRAs save you money on your taxes now, it makes sense to open a Roth IRA if you think you'll be in a higher tax bracket when you retire than you're in right now. Otherwise, a traditional IRA might be for you -- especially if you're looking for a way to reduce your current tax liability.
Whatever you choose, the most important thing to do is to start saving for retirement now if you can -- and an IRA is one of the best vehicles for that.